On September 23, 2009, the State Duma of the Russian Federation adopted in the first reading the draft Federal Law No. 217052-5 "On Amendments to the Federal Law 'On the Securities Market'" (regarding the establishment of mechanisms aimed at protecting the rights of bondholders). The adoption of such a law is undoubtedly an important step for the development of the Russian securities market. However, some provisions of the Draft require further discussion, as their proposed resolution appears debatable.
This document proposes to introduce into legislation provisions allowing bondholders and the issuer to modify the issuer's obligations under the bonds during their circulation period (including for the purpose of restructuring the bond debt).
Furthermore, the draft Federal Law No. 217052-5 "On Amendments to the Federal Law 'On the Securities Market'" (hereinafter – the "Draft") envisages provisions whereby a specially appointed person – a representative of the bondholders – may act on behalf of the bondholders to protect their interests. This article sets forth proposals on a number of points (within the framework of discussing the Draft) which, in the author's opinion, could eliminate the Draft's shortcomings and improve its quality.
In doing so, we rely, inter alia, on the standards of international practice for bond issues from leading countries in this area, such as England, the USA, France, Germany, Japan, on foreign practice regarding specific transactions, judicial practice, and scholarly literature.
Competence of the General Meeting of Bondholders and the Representative of the Bondholders
Draft
The Draft establishes matters falling within the competence of the general meeting of bondholders (clause 12, Article 27.1.3 of the Federal Law "On the Securities Market" in its new version, considering the norms of the Draft (hereinafter – the "Law")). According to the Draft, these matters cannot be assigned to the competence of the representative of the bondholders (including as part of its exclusive competence).
Thus, pursuant to the Draft, the representative of the bondholders cannot decide on behalf of all bondholders to waive the right to demand early redemption of the bonds; to waive the right to demand performance of obligations under the bonds from the person providing security for the bonds; or to agree on the terms for termination of the issuer's obligations to the bondholders (subclauses 2, 3, and 5, clause 12, Article 27.1.3 of the Law).
Moreover, according to the Draft, the representative of the bondholders is only entitled to agree to such amendments to the offering documents that are related solely to the correction of technical errors (subclause 1, clause 13, Article 27.1.2 of the Law).
Necessary Legal Regulation
The aforementioned matters under English and US law often fall within the competence of the bondholders' representative (trustee). Therefore, the distribution of competence between the general meeting of bondholders and the representative, as established in the Draft, requires amendment towards greater flexibility (dispositivity).
Legislation should allow for the competence of the general meeting of bondholders and the representative to be established contractually. This includes legislation allowing for the possibility of granting the representative of the bondholders the exclusive right to exercise certain powers on behalf of the bondholders. Legislation should also allow for amendments to the offering documents with the consent of the representative (without the need to convene a general meeting of bondholders). Such a procedure should apply if it is stipulated in the bond terms and conditions (resolution on the bond issue) and concern amendments that are not material to the bondholders (including those not related to the timing and amount of bond payments).
Bonds are a universal instrument that can be used in many types of transactions with various purposes and issuance terms, which requires granting participants in financial transactions greater freedom in determining bond conditions. In this regard, contractual (dispositive) regulation is best suited for distributing competence between bondholders and their representative. Thus, (a) bondholders can be different institutions (including varying in their level of professionalism and readiness for independent action); (b) bond issuance terms can be extremely simple or, conversely, complex (and, accordingly, requiring a special mechanism for amendment, control, and enforcement); (c) bond circulation periods can be short or long; (d) bonds can be used for different types of financial transactions (corporate, project finance, infrastructure, or backed by revenue from real estate or other specific assets, or backed by revenue from a loan portfolio or other monetary claim rights).
Legislation may establish minimum requirements for provisions in the bond terms and conditions and the prospectus, which the regulator deems necessary to regulate for the protection of the rights of investors, the issuer, and the representative of the bondholders. However, legislation should grant the right to modify such requirements upwards (or downwards – depending on the nature of the requirement) to allow market practice for regulating the relevant relations to develop.
Mandatory Submission of the Demand for Early Redemption of Bonds by the Representative of the Bondholders
Draft
The Draft stipulates that if a ground for early redemption of the bonds at the demand of their holders arises, (1) the representative of the bondholders is entitled to present the bonds for early redemption only if such a decision is adopted by the general meeting of bondholders; and (2) if the general meeting of bondholders does not adopt a decision to waive the right to make such a demand within two months, the representative of the bondholders is in any case obliged to present the bonds for early redemption (clause 6, Article 27.1-1 of the Law).
Furthermore, the representative of the bondholders is obliged to convene a general meeting of bondholders upon the occurrence of any event entitling the bondholders to early redemption of the bonds.
Necessary Legal Regulation
Upon the occurrence of a ground for early redemption of the bonds at the demand of their holders, the right to demand early redemption of the bonds should belong to (a) the representative of the bondholders and/or (b) bondholders holding collectively a certain number of votes (usually 25 percent). That is, to persons authorized by the bond terms and conditions. The requirement to redeem the bonds early should not automatically become an obligation of the representative solely because the bondholders have not adopted (or did not have time to adopt) a decision on this matter. For instance, the ground for early redemption may be cured or eliminated by the issuer, or the representative may waive the exercise of the bondholders' rights (due to inexpediency from the perspective of the bondholders' interests).
Moreover, the Draft's requirement to convene a general meeting of bondholders for early redemption is unnecessary, as the bond terms and conditions may provide (in accordance with international securities issuance practice) that bonds can be presented for early redemption without a decision of the bondholders' meeting, or that the representative of the bondholders can independently decide not to demand early redemption of the bonds.
For example, the bond terms and conditions may stipulate that a ground for their early redemption is the occurrence of an event of default, which, in turn, occurs provided that (a) the representative (or bondholders holding the number of votes specified in the bond terms and conditions) notifies the issuer (and the representative) of the occurrence of the default (as defined in the bond terms and conditions); and (b) the issuer does not cure the default (e.g., by performing the unfulfilled obligation of the issuer) or the bondholders (their representative) do not waive the exercise of their rights arising from the default within the period specified in the bond terms and conditions. In this case, the representative of the bondholders (or bondholders on behalf of all bondholders) is entitled to demand early redemption of the bonds (without the need for a decision by the general meeting of bondholders).
Alternatively, the bond terms and conditions may stipulate that a ground for early redemption of the bonds is the occurrence of an event of default, which occurs (a) if the issuer fails to perform any obligation set forth in the bond terms and conditions (except for the non-payment of bond payments within a specified period, which usually necessarily triggers the right to demand early redemption); and (b) in the opinion of the representative of the bondholders, such failure by the issuer to perform its obligation is material to the exercise of the bondholders' rights. In this case (as in the first example above), a decision by the general meeting of bondholders is not required, as the representative can independently determine whether a ground for early redemption has occurred and whether there is a need to demand early redemption of the bonds.
The time limits for submitting a demand for early redemption of the bonds and other additional conditions for submitting such a demand should also be established in the bond terms and conditions (legislation may define minimum requirements (time limits), granting the right to modify them upwards (or downwards – depending on the nature of the requirement).
Arise of the Right of Bondholders to Individually Submit Demands for Early Redemption of Bonds
Draft
The Draft stipulates that each bondholder is entitled to individually submit demands for early redemption of the bonds if the representative of the bondholders does not submit such a demand on behalf of the bondholders within two months. Furthermore, a bondholder will be able to demand early redemption of the bonds in their own name even if the bondholders have not adopted a joint decision to submit such a demand (clause 7, Article 27.1.1 of the Law).
Thus, according to the Draft, upon the occurrence of a ground for early redemption of the bonds, each bondholder is entitled to demand early redemption of the bonds in their own name based solely on the fact that such a demand was not submitted to the issuer by the representative of the bondholders.
Necessary Legal Regulation
Meanwhile, the approach to the individual submission of demands by bondholders should be different: (1) the bondholders have adopted a decision on early redemption of the bonds; (2) the representative failed to execute this decision within a specified period; and as a consequence – (3) the bondholders acquire the right to submit a demand for early redemption of the bonds on behalf of all bondholders. Thereby, bonds will not be presented for early redemption by individual bondholders in cases where a decision on such a demand was not adopted by a joint majority of the bondholders (i.e., in cases where the decision on such a demand was not adopted by bondholders holding the number of votes required for such a decision according to the bond terms and conditions).
Restricting individual actions of bondholders and replacing them with a collective action principle is one of the purposes of using the general meeting of bondholders and the representative in the offering documents (to ensure the stability of bond financing and protect the interests of the majority of bondholders). For example, restricting the right of a bondholder to submit a demand in their own name can be useful for cases where a breach of the offering documents can be cured by the issuer (or the bondholders (their representative) waive the exercise of their rights arising from such a breach of the offering documents) and, in the opinion of the majority of bondholders, there is no need to redeem the bonds early.
The procedure for the arise and exercise of the right of bondholders to submit demands individually should be established contractually. In particular, the period specified for the representative of the bondholders to submit a demand to the issuer, after the expiration of which the bondholders acquire the right to submit demands individually, is usually stipulated directly in the offering documents (but not in the law) and typically amounts to 60 days. Legislation may establish minimum requirements (time limits), granting the right to modify them in the offering documents upwards (or downwards – depending on the nature of the requirement).
Mandatory Appointment of a Representative of the Bondholders
Draft
According to the Draft, the appointment of a representative of the bondholders is mandatory if the bonds are placed by open subscription (subclause 1, clause 2, Article 27.1.2 of the Law).
Necessary Legal Regulation
Such a requirement is unnecessary and may lead to a significant increase in the cost of the bond issuance procedure in cases where the powers of the representative of the bondholders are not required (e.g., in bond issues with a short circulation period; or in bond issues that will not be traded on a stock exchange).
The appointment of a representative of the bondholders should not be mandatory under the law, and the necessity of its appointment should be determined by the specific conditions of the particular issue (and the wishes of the investors). If a representative of the bondholders is not appointed by the issuer (or elected by the bondholders), the bondholders should be granted the right to exercise their rights vis-à-vis the issuer (other obligor under the bonds) directly.
Replacement of the Representative of the Bondholders
Draft
The Draft requires registration of amendments to the bond terms and conditions for the replacement of the representative of the bondholders (clauses 8, 10, Article 27.1.2 of the Law). This means that until the completion of the procedure for the registration authority to review the application for registration of amendments to the bond terms and conditions and the registration of such amendments (which may take from 30 to 60 days), the new representative of the bondholders will not be able to commence exercising its powers.
Necessary Legal Regulation
The powers of the representative of the bondholders, in case of its replacement, should terminate from the moment the decision on such replacement is adopted or from another moment specified in such decision. There should be no gap between the termination of powers by the outgoing representative of the bondholders and the newly appointed representative of the bondholders (as its powers must be exercised continuously). Therefore, the commencement of the powers of the new representative of the bondholders should not be made dependent on the registration of amendments to the bond terms and conditions, but should be determined by the decision on the appointment (election) of the new representative.
Personal Exercise of Powers by the Representative of the Bondholders
Draft
According to the Draft, the representative of the bondholders must perform its duties personally (clause 11, Article 27.1.2 of the Law). This means that the representative of the bondholders will not be able to engage other persons to perform its duties.
Necessary Legal Regulation
Such a requirement is unjustifiably excessive. If necessary, the representative of the bondholders should have the right to engage third parties (auditors, technical experts, law firms, and other consultants) to ensure the most effective and professional protection of the interests of the bondholders.
Obligation of the Representative of the Bondholders to Execute Any Decision of the General Meeting of Bondholders
Draft
The Draft establishes an unconditional obligation for the representative of the bondholders to execute any decision of the general meeting of bondholders (subclauses 1, 10, clause 12, Article 27.1.2 of the Law).
Necessary Legal Regulation
Such an unconditional obligation of the representative of the bondholders to execute any decision of the general meeting of bondholders implies a risk for it of incurring costs, the approximate amount of which cannot be assessed in advance. This, in turn, may lead either to professional participants refusing to provide representative services, or to the representative's fee being very high.
To eliminate such risk, legislation should provide that the representative must execute a decision of the general meeting if (1) such an obligation regarding specific decisions is expressly established in the offering documents, or (2) provided that the bondholders reimburse the representative for the expenses of executing such decision.
Reporting Requirement for the Representative of the Bondholders
Draft
The norm of the Draft regarding the provision of documents and information by the representative of the bondholders to the bondholders and the regulatory authority is formulated vaguely and may lead to disputes regarding which documents and information this is mandatory for (subclause 8, clause 12, Article 27.1.2 of the Law).
Necessary Legal Regulation
The said norm places representatives of the bondholders in an uncertain position (as bondholders and the regulatory authority may demand the provision of information that does not directly affect the interests of the bondholders but concerns the activities of the representative of the bondholders, and the disclosure of which is inadmissible for the representative). This could significantly narrow the market for representative services (or lead to their increased cost).
Therefore, the documents and information that the representative is obliged to provide to the bondholders, as well as the procedure for doing so, should be determined in the offering documents.
The documents and information that the representative of the bondholders is obliged to provide to the regulatory authority, as well as the procedure for their provision, should be clearly established by law or other regulatory act.
Right of the Representative of the Bondholders to Demand Information from the Issuer, its Auditor or Appraiser
Draft
The Draft establishes the right of the representative of the bondholders to demand necessary information from the issuer, its auditor, or appraiser (subclause 2, clause 13, Article 27.1.2 of the Law). However, the obligation of said persons to provide such information and the procedure for such provision are not enshrined in the Draft.
Necessary Legal Regulation
The list of information and documents that the issuer must provide to the bondholders and/or their representative should be established in the offering documents. The law should only enshrine the obligation of the issuer to provide such information (to eliminate ambiguity in case of disputes regarding the existence of such an obligation of the issuer).
The right of the representative to demand information from the issuer's auditor and appraiser seems excessive, as if it is necessary to obtain any information related to the exercise of rights under the bonds, it is sufficient to impose the obligation to provide the necessary information on the issuer (other person obligated under the bonds). The activities of third parties (including the issuer's auditors, appraisers) should not be affected.
Presence of the Representative of the Bondholders at General Meetings of Members (Shareholders) of the Issuer
Draft
According to the Draft, the representative of the bondholders is entitled to attend general meetings of members (shareholders) of the issuer in a non-voting capacity (subclause 6, clause 13, Article 27.1-2).
Necessary Legal Regulation
The right of the representative to attend general meetings of members (shareholders) of the issuer is not a universal means of protecting the interests of bondholders but may, in the opinion of some issuers, restrict the activities of the issuer.
Nevertheless, if such a requirement is material for investors, it can be agreed upon and established in the offering documents. And legislation should grant the representative such right to attend the general meeting in cases where it is provided for by the bond terms and conditions (to eliminate ambiguity regarding the possibility of such a right of the representative).
Maximum Amount of Remuneration for the Representative of the Bondholders
Draft
The Draft requires establishing the maximum amount of payment for the services of the representative of the bondholders in the manner established by the federal executive body for the securities market (clause 14, Article 27.1.2 of the Law).
Necessary Legal Regulation
Such a requirement is unnecessary and should be agreed upon (if necessary) between the parties, as it is impossible to calculate in advance an amount of remuneration that would adequately reflect all the representative's costs and an acceptable level of profit for it. It should be noted that in international practice, such a requirement (to set a maximum remuneration amount) existed for a long period, but stress situations showed that the termination of representation due to the exhaustion of the maximum remuneration amount leads to greater financial losses (which exceed the representative's remuneration). In this regard, practice has changed, and the establishment of a maximum amount of remuneration for the representative of the bondholders is no longer required mandatorily but is provided for at the desire of the participants of the relevant transaction.
Costs of Convening and Holding the General Meeting of Bondholders
Draft
According to the Draft, if the general meeting of bondholders is held at the request of a person(s) holding not less than 10 percent of the outstanding bonds, the costs associated with convening and holding the general meeting of bondholders are borne by the bondholder(s) requesting its holding (clause 7, Article 27.1.3 of the Law).
Necessary Legal Regulation
This rule may lead to bondholders not convening a general meeting even in cases where bondholders need to resolve material issues (due to the necessity of bearing the costs of convening and holding the meeting).
The costs associated with convening and holding the general meeting of bondholders should be borne by the issuer (except in cases of abuse by the bondholders of their right to convene a general meeting of bondholders, disputes about the presence or absence of which will be considered by the court).
Furthermore, a judicial procedure for convening a meeting in case of the issuer's refusal to convene a general meeting of bondholders is also possible: (a) the person requiring the convening of the general meeting of bondholders, after receiving the issuer's refusal, applies to the court to resolve this issue; (b) the court issues a ruling on convening the meeting if it finds that there are no grounds for refusing such convening. In this case, the issuer will not be able to challenge bearing the costs of convening and holding the meeting of bondholders, as they were preliminarily sanctioned by the court.
General Meeting of Bondholders in State (Municipal) Securities Issues
Draft
The Draft specifically excludes issues of state (municipal) securities from the scope of the Law's norms on the general meeting of bondholders and their representative (clause 5, Article 19 of the Law).
Necessary Legal Regulation
Apparently, this exclusion of state and municipal securities issues from the scope of the norms on the general meeting of bondholders and their representative is explained by the fact that currently, issues of private and state (municipal) issuers are regulated by different laws (the Federal Law "On the Securities Market" and the Federal Law "On the Specifics of the Issue and Circulation of State and Municipal Securities", respectively).
Nevertheless, it should be noted that the regulation of (a) the possibility of amending offering documents; (b) representation of bondholders should not differ substantially for sovereign securities issues from the regulation for issues of private issuers. This is explained, in particular, by the fact that state issuers should not have the ability to forcibly restructure bonds or declare them invalid, or change the terms of circulation without the consent of investors. On the other hand, bondholders should have the ability to adopt decisions by majority vote that are binding on all bondholders, in order to change the terms of circulation of the bonds (or otherwise bind all bondholders).
Representative of the Bondholders in Issues of Bonds with Mortgage Coverage
Draft
The Draft specifically excludes issues of bonds with mortgage coverage from the scope of the Law's norms on the representative of the bondholders (clause 17, Article 27.1.2).
Necessary Legal Regulation
Legislation on mortgage securities provides that the interests of holders of mortgage securities shall be protected by a specialized depository.
However, it does not provide for a number of most important powers of the specialized depository (which is explained by the lack of necessity for them under the current legislation): (a) the specialized depository does not act on behalf of all holders of mortgage securities; (b) the specialized depository does not have the exclusive right to make demands under the bonds to the person obligated under the bonds (debtor).
In general, it should be noted that securities legislation should establish general provisions on the representative of the bondholders, and legislation on mortgage securities should establish special rules.
Such regulation will avoid contradictions between the general status of the representative of the bondholders and the status of the representative of the holders of mortgage securities, for which there are no grounds for differences (between the general rules for the representative of the bondholders and the representative of the holders of mortgage securities).
General Meeting of Bondholders in Case of Initiation of Bankruptcy Proceedings against the Issuer
Draft
According to the Draft, the general meeting of bondholders cannot be convened if the issuer is declared insolvent (bankrupt) (paragraph 1, clause 1, Article 27.1.3 of the Law).
Necessary Legal Regulation
First, the ambiguity of this norm should be noted. Does it mean that in case the issuer is declared bankrupt, only the convening of a meeting of bondholders is impossible and that all issues related to the exercise of rights under the bonds can only be decided by the representative at its discretion? Or does this norm imply a complete prohibition on bondholders exercising their rights collectively (both through the general meeting and through the activities of the representative of the bondholders)? In the first case (prohibition on convening a meeting), it is unclear how bondholders are entitled to act (each in their own name or jointly) if a representative of the bondholders was not appointed or is absent.
Second, under Russian bankruptcy law, in case the issuer is declared bankrupt, the rights under bonds of one issue should be exercised in the same manner as before the issuer was declared insolvent (by decision-making by bondholders by majority vote and (or) through representation).
If bankruptcy proceedings are initiated against the issuer, the issuer's obligations to the bondholders do not terminate, and the offering documents remain in force; therefore, the bondholders and the representative should exercise their rights and obligations in the usual manner.
Thus, during bankruptcy, bankruptcy creditors can make decisions regarding the modification/termination of the debtor's obligation (by concluding a settlement agreement), the pledge securing the debtor's obligation (e.g., determining the procedure and conditions for auctions to sell the pledged asset). These decisions of the bondholders should be adopted in the general manner – either by the representative of the bondholders or by the bondholders by majority vote.
Thus, bondholders are entitled to jointly make decisions binding on each of them at any time during the existence of the obligations under the bonds, including in the case of initiation of bankruptcy proceedings against the issuer.